Third wave of the coronavirus pandemic slowed down expected economic recovery in the Euro area. Trade, transport, entertainment, and hospitality are among the sectors that were affected by targeted regional lockdown the most. Industrial sector, on the other hand, is recovering at a faster pace due to improved foreign demand. Median debt-to-equity ratio in the region was approximately 85% in the last quarter of 2020, while some corporations, in the tail, held debt-to-equity ratios above 270%. Higher interest rates – in a likely structural supply chain imbalances driven inflation scenario – would imply higher debt-servicing costs, causing such companies to collapse and impacting the suppliers. Increased credit risk is expected to materialise in the region, causing vulnerability to bank and corporate balance sheets.
Economic recovery in the Euro area is slower than expected due to the third wave of coronavirus infections. In contrast with the impact of the first and second wave, the third wave had an extremely concentrated impact. Sectors that were severely impacted are trade, transport, hospitality, arts, and entertainment. These sectors have seen a decline of a factor 2 or even 4 of gross value added when compared the aggregate.
Furthermore, the region is recovering at a slower pace due to the difficulties of vaccine roll-out at the beginning of the 2021. However, looking ahead, a drop in infections and effective vaccine policies will have a very positive impact on the economic recovery of the Euro region. In contrast with sectors mentioned above, industrial sector is recovering at a faster pace due to improved foreign demand. They are however increasingly facing bottlenecks in deliveries and are faced with booming commodity prices.
Corporate revenues declined more than gross value added in 2020, putting additional pressure on corporate solvency. Gross profits in 2020 were 8.1% below the levels of 2019. As a result, retained earnings plummeted. A sharp and persistent drop in corporate savings will have a significant impact on future investment policies, increasing downward pressure on economic recovery.
Corporations took on more debt throughout the pandemic in order to build up liquidity buffers. Even so, SMEs had more difficulties obtaining additional liquidity at a fair price in contrast with large, listed companies that had immediate access to market-based funding. The median debt-to-equity in the last quarter of 2020 reached approximately 85%. On the other hand, debt-to-equity ratio reached 270% in the 90th percentile. Potential higher risk-free rates that might be necessary to moderate inflation pressures stemming from the supply shocks would increase debt financing cost, pushing “zombie” companies over the cliff. In the last two quarters of 2020 new corporate loans fell as banks began to tighten lending conditions.
Balance sheets of banks and corporations are extremely vulnerable due to high credit risk across the region. These risks are expected to materialise in losses as corporations, which where permanently damaged by the pandemic, will be unable to service their loans and invoices. Furthermore, effective managing of non-performing loans (NPLs) will be extremely important in order for banks to maintain strong balance sheets and be able to support lending, contributing to a faster pace of economic recovery. To prevent supply-chain disruptions and secure heathy balance sheets, corporations must be as diligent at managing credit risk as banks and other financial institutions. Monitoring exposure and regular credit report analysis is a must. Corporations should beef up their trade credit insurance policies – a very effective risk management tool for (trade) credit risk.
This article was written by the team at ALPHA CREDO
ECB (2021). Financial Stability Review. Available here